Category Archives: Late Payment Charges

As the deadline of 1st January 2015 to comply with the new Reference Rate Framework looms closer, Banks are scrambling to ensure the system is adequately able to cater for the new pricing regime.

To refresh what this initiative is all about, BNM has earlier in March 2014 issued the final paper for the Reference Rate Framework, the purpose being to move Banks to be more transparent in their pricing regime and start thinking about risk-based pricing more seriously. It is also expected to push Banks to be more efficient in their operations; the more efficient the funding infrastructure, collections and recovery teams in the Bank, the lower the expected risks associated to the pricing which means bigger “savings” on the margin for the Bank.

Which was fine when I read it a few months ago. For a quick recap, do read my earlier post:

But the more we go into this Reference Rate project, the more confused I get. Reading again and again and comparing it with the earlier Guideline issued by BNM on Risk Informed Pricing (issued 13 December 2013), I realised while earlier we understood the concept of “building the element of risk into how we calculate pricing”, this Reference Rate Framework talks about something else. Something I am inclined not to agree to.

Before that, what is Risk-Informed Pricing or Risk-Based Pricing?

I am not sure if there is a difference between the two, but the general understanding of what is Risk-based pricing and the explanations in the BNM paper on Risk Informed Pricing sound similar; both talk about Expected Loss being the justification of charging a higher financing rate to consumers deemed to be “credit unworthy”. There is an element of discrimination but certain rules have been put in place such as factors that should NOT be used to determine price, such as race, colour, religion, national origin, gender, marital status or age, but that leaves a lot of interpretation by Banks on what can be defined as “risk” factors of a consumer. Wiki even went to comment that the pricing convention hurts the financially disadvantage from access to affordable capital or financing. This leads to predatory lending where Banks may offer exorbitant rates to desperate customers as they have no choice but to enter into an unsustainable financing schemes that they will eventually default.

Does Risk-Based Pricing make sense for Islamic Banking?

In that sense, how do we, Islamic Bankers, deal with Risk-based pricing in the context of the new Reference Rate regime? Is there such as thing as risk-based pricing for Islamic Banking?

Personally, I view Risk-Informed Pricing to be in contradiction to Islamic Banking and what we are supposed to do for consumers. Many efforts have been made to ensure consumers are not unnecessarily burdened but instead to provide assistance. We understand the Bank’s needs to discourage consumer “who couldn’t afford it” to not borrow further and bring themselves into unsustainable debts. But the way of the world, with the Basel II accord being an important international standard, risk is deemed to have a direct impact on Bank’s capital and therefore must be addressed accordingly via effective risk management where one of the methods for this is to have risk-informed pricing. Therefore, upon assessment of an application from a consumer, a “risk-informed” price will be offered for their consideration; a price where all the elements of risks (including Expected Loss) are built into additional costs and premiums.

Islamic Banking, like it or not, will still fall under such standards, and therefore will already “penalise” a certain unfortunate consumer upfront with a “risk-informed” pricing. Not something consistent with what I feel Islamic Banking should do.

What is it that I am confused about with the Reference Rate Framework?

While we have woken up and accepted that the world now is moving towards “risk-informed pricing”, we try to find ways to soften the burden to consumers by regulating “late payment charges” and”early settlement charges”. The Late Punitive pricing was also off the radar for both conventional banking and Islamic banking.

But with this new framework, there is not only “Risk-Informed pricing” or “Risk-Based Pricing” but also “Risk-Adjusted Pricing”. Adjusted means Banks can adjust pricing AFTER a future event happening.

This concern basically boils down to this particular clause in the framework paper.

Usually, risk-based pricing means initially a price that is adjusted to cater to the risk are given upfront. But with 8.10, what this means is that if the credit risk profile or creditworthiness of the customer changes during the tenure of the financing, the pricing i.e. the Bank’s spread may be revised to compensate for the higher risks. Definition of changes of the “credit risk profile” or “creditworthiness”, based on our clarification with BNM, refers to default situation. Therefore, if a customer’s creditworthiness is compromised and becomes worse-off, then the Bank, in its facing additional risk for continuing to finance the customer, may revise the Bank’s spread to mitigate the higher risks. If you are a good paymaster for 1 year but on the 13th month is out of a job and unable to pay your home instalments, you are now “not-creditworthy” and the Bank has the “right” to mitigate that risk and charge a higher spread i.e. higher returns.

Unless I’m reading this standard wrong, this is a gross expansion to risk based pricing, where the facility rates are adjusted based on the customer’s prevailing risk profile.

Yes, if the customer’s risk profile shows good credit standing (therefore deemed a “low credit risk”), theoretically the customer may enjoy a low financing rate for their facility due to the low possibility of default to the Bank. This is definitely a benefit to the customer. But on the flipside, if the customer initial credit rating is already “marginal or bad”, they possibly will be offered an “elevated” Bank’s spread to mitigate the potential risks of financing an “unworthy” customer. Therefore the initial pricing will be higher than usual. This is the basis of risk-based pricing, which can be a beneficial tool for the Bank.

To make things worse, should the customer have no choice but to take the financing at a higher rate, they are open to further “elevation” if during the course of the financing, things go sour in their payment. The event of default will trigger the option to “revise” the rate further. This means a “marginal or bad” customer will be holding on two levels of risk-adjusted pricing; the first during the initial approval, and the second on default events during the financing period.

It seems there is now a backdoor to the Late Payment Charges (LPC) that the Islamic Banks have been restricted to. While it is difficult to charge Penalty (Gharamah) due to various restrictions, allowing Banks to directly revise upwards the banking spread actually resolves the issue of cost compensation that Banks were not able to charge before. In fact, if you really think about it, there is really no need for the LPC guidelines anymore; on default, Banks can raise the pricing spreads and it goes directly (and fully) into its income books.

How will this be acceptable to an Islamic Banking structure? Allow me to express my utmost shock to this.

Simply put, risk-adjusted pricing and Islamic Banking do not make good companions. I understand the intention is to ensure customers don’t over-finance beyond their means, but to impose this for “default” customers does not seem right as this looks very similar to a punitive action to consumers. I hope I am wrong about this, but as I know it, my conventional banking counterpart is already building this capability in their system. As this is a BNM standard now, I wonder how soon until we are asked to follow suit to comply with such requirements.

I am recording my official concern to this to my organisation’s Sharia committee. Hopefully it is a misunderstanding on my part. I would welcome this correction in understanding on my behalf.

The following is what I understood from the various Exposure Drafts issued by BNM on 9 December 2013. Of the 7 exposure drafts that we received, I have earlier summarised the Wadiah Exposure Draft, and I will ignore the Bai-Inah Exposure Draft as we are no longer subscribing to the Bai Inah structure at the workplace.

2013 ED – Kafalah – One of the key issues for a Kafala (Guarantee) contract is the charging of fees for providing the guarantee services. The main issue has always been the quantum of fees charged, either in percentage of the financing or via a fixed charge for all financing amount. The justification of this charge is always tricky, because technically the fee should not be imposed if there is no call for the guarantee (in cases of no default). The guarantee will only materialise if the customer defaults, that’s when the work happens to justify any fees. Issuing a piece of paper at the start of the relationship to guarantee the amount does not amount to too much work, and there no funds disbursed to any parties (unfunded). To justify the charging of any fees based on percentage instead of actual work, especially for huge amounts of financing guarantee, can be problematic to justify in the eyes of Sharia.

2013 ED – Wa’d – At one point of time, Wa’ad (Promise) seems to be the answer to many structures, where a promise is given without any requirement to transact before a specific event. The terms therefore can be negotiated and re-negotiated without the need to strictly specify the terms of the transaction and re-signing of documents. This gives a lot of leeway for deals to happen.However, at the end of the day, Wa’ad remains as only a promise, legally distanced from a contract or an agreement. Enforcement at the courts are therefore without full confirmation of all the terms, and makes for a loose structure and potential disputes. This flexibility and enforceability remains one of the key risks to a Wa’ad contract, which is why until today Wa’ad is generally transacted between known parties i.e. between established and trusted Financial Institutions.

2013 ED – Wakalah – Wakala (Agency) will remain an integral contract for Islamic Banking as it validates a lot of action that can be done by the Bank, in order to remain efficient. In general, Banks hold a lot of expertise in various fields, such as investments, financing, leasing and trading; something a normal customer may not want to be involved in on a daily basis. An Agency arrangement conveniently provides for this. Anything that improves the efficiency by leveraging on the Bank’s expertise and infrastructure, can be arranged via Agency. However, the way we practice it usually is transparent to the customer. In practice, Agency Fees are the right of the Agent, and the waiver of such fees, although allowed, is sometime seen as not adhering to the spirit of Agency and entrepreneurship. You do the work as an Agent, but don’t earn any fees as it is waived. In real life, this does not happen as whenever a work is completed, you should earn something.

2013 ED – Tawarruq – As Tawarruq (Three-party Murabaha Sale) becomes more prominent in the Malaysian market, I was surprised that the ED was not more comprehensive than this. There are sequencing issues not addressed but more importantly, there is a lack of illustration on what is defined as Tawarruq. Is there any difference between a Tawarruq and Commodity Murabaha, which essentially is a 4 party transaction? The issue of interconditionality is adequately addressed in the ED but I would love to have seen more details related to products, such as for Islamic Credit Cards and Revolving Credit with a rebate structure (Ibra’) based on a floating rate financing. It mentions that the discount can be given based on certain benchmark agreed by the contracting parties. This opens the clause to various interpretation as it is without real detail.

I will look at the Hibah (Gift) ED but essentially, it is related to the Wadiah ED. Most of what’s covered under the Hibah ED is relevant to the Wadiah product, such as the discretionary Hibah issue and the giving of Hibah becoming a business practice (Urf Tijari) which can be construed as Riba (Usury). Wait for the posting.

Thank you for reading, hope everyone have an enjoyable holiday period ahead. Wasalam.